Hamish McRae: Sovereign wealth funds: the power barons who will change our markets

Will sovereign wealth funds save the Western world's financial institutions in much the same way that demand from the BRICs may save the world from a global recession?

It is fascinating to see where stricken US banks turn when they need cash fast: the Middle East and Asia. But that is where the money is, mostly in sovereign wealth funds, which are acting like investors of last resort for the US equity markets.

This is money that can be committed by the decision of a handful of individuals, maybe just one person, rather than the bureaucratic process that Western investment institutions undergo. It is money that seeks a long-term home and is not influenced by the spurious ranking of the rating agencies or the dubious appraisals of the market analysts. And it is money that does not have to fit in with the tail-covering requirements of Western regulatory bodies.

So it is not just the geographical location of these investors that is different; their whole decision-making process is different. And that will change equity markets radically in the years to come.

The markets are focusing, understandably enough, on what has happened to Citigroup and Merrill Lynch and the various other financial institutions that have had to shore up their balance sheets. Is the worst over? Are the losses now priced into the share price? How will an economic downturn affect bad debts and hence future profits?

Those are perfectly sensible questions, and in the context of what looks like becoming the worst start to a year for shares since the Second World War the obvious ones to be asking right now. But there are also longer-term consequences of what is a shift of financial power of historic magnitude, a much bigger shift of power than took place for example after the oil shocks of the 1970s and 1980s.

To see why, you have to appreciate the scale of what is taking place. I have not been able to find any official data, but a quick back-of-an-envelope calculation suggests that governments in the Middle East and Asia are now the largest category of net investors in Western equity and bond markets. Their stock of holdings is still small; but the additional money being ploughed into these markets from these sources is larger than the net flow from US or European investment institutions.

The facts that are available are the rankings of the various SWFs and the size of central bank reserves – see the first two charts. The reason for showing both is that sovereign wealth funds are really a substitute for central bank reserves. Intellectually they are quite different: the former are for the long-term security of the country in question's citizens; the latter to enable the central bank to meet demand for foreign exchange as a result of trading imbalances and hence in effect to manage the exchange rate. But both are owned by the nation, and it makes sense once reserves are at an adequate level to try to get a better return on them. So they can be switched from short-term US Treasury securities, their most common home, into shares and longer-term bonds.

That is what has been happening, and expect it to continue. SWFs now total a little over $2,000bn, but it is perfectly plausible that in five years' time that figure could be five times that amount. You can see how this compares with the present size of global share and bond markets in the third chart. Global equities are valued at around $28,000bn, and global bonds $25,000bn. So at the moment in terms of the stock of funds, not the flow, SWFs are not that significant. Presumably there will be some rise in global equity and bond markets in the next five years, but even so, were SWFs to split evenly between equities and bonds and have $5,000bn in each they would account for something between 10 per cent and 20 per cent of the total. That is material.

So how might these new power barons change global markets? I suspect they will change equities more than bonds, because the latter do not involve the owners in such high levels of involvement and scrutiny. This is guesswork, but here are some suggestions.

The first change is that they will make share markets take a longer-term view and probably become less volatile. If you have 15 per cent of global equities anchored in solid national funds that will be enough to discourage frivolous merger activity. There will be less of a churnof holdings in share registers and less pressure on other investors to churn their holdings between different companies and sectors.

The second change is that managements will be clear to follow longer-term objectives, knowing that they have the backing (assuming they do) of a large chunk of their shareholding body. Big changes in direction will have to be cleared with the SWFs, which will not be so influenced by the latest fad of the analyst community.

Third, a point made by Morgan Stanley in a new paper on SWFs, big-cap stocks will be favoured over mid-caps and small ones. It will not be worth the bother of SWFs to chase around scattering their investments over a large number of holdings. If that is right, this will create opportunities for investors with the time and resources to examine smaller investment opportunities.

Fourth, equities will be favoured over bonds. It will suit the long-term objectives of SWFs to revitalise the cult of the equity. On a very long view, equities outperform bonds. SWFs can take a very long view because they don't have to comply with often arbitrary obligations imposed by national regulatory agencies.

Fifth, private equity will boom as SWFs will use this channel for investment. But they will be tough and innovative: expect them to form their own private equity enterprises rather than simply give money to established Western ones.

Finally, something that happen but only to a limited extent. There will always be a possibility that SWFs will be used to foster national political objectives rather national economic ones. I would be surprised if there are no instances of this over the next few years. But if there is, there will be strong political opposition, and it will not be in the long-term self-interest of the investing nations to be seem to use their funds in an overtly political way. The long-established SWFs, such as that of Kuwait, have always been extremely apolitical, you might say responsible, in the way they have deployed their financial power. That may not always be the case for all SWFs in the future, but I think we can be reasonably optimistic in the future.

But power will shift; there is no doubt about that. So the ethical and environmental values of these "new" investors will come to rank higher in the spectrum, and the values of the present investment community will tend to lose sway.

The shift will be gradual, of course. Different SWFs will have different objectives. The majority of shareholders in most corporations will still come from the developed world. But I don't think we should underrate the significance of the power of this new barony. It may become as important as the shift from personal investors to institutional ones that took place from the 1950s onwards, and that shift totally changed the way the markets worked.